Feds double up on bad financial hand

December 25, 2008

Freedom New Mexico

This month’s announcement by the Federal Reserve Board that it has cut its benchmark overnight federal funds rate, the rate at which banks lend to one another, to a “target range” of between one-quarter percent and zero is both an acknowledgment of reality and a sign of panic.

Since banks, even in the wake of huge infusions of capital from both the Treasury and the Fed, aren’t lending much to each other, anyway, the effective interest rate was already close to zero.

By setting its “target” rate at close to zero, the Fed essentially made public that, for the foreseeable future, the traditional method the Fed uses to try to pump up a flagging economy — lowering interest rates to loosen the credit markets — won’t work.

Here’s where the panic comes in.

At the same time the Fed announced it will adopt what it calls more unconventional means to try to pull the economy out of recession — buying all kinds of credit-based securities, including those based on auto loans and credit cards as well as mortgages — to try to get banks to extend credit more liberally.

The problem with this approach is it is doubling down with the same kinds of policies that helped to create the housing bubble that precipitated the financial panic and the financial crisis and the economic slowdown in the first place. It is a short-term approach that carries significant long-term risks.

Esmael Adibi, who heads the Anderson Center for Economic Research at Chapman University, said printing money and pumping credit into the economy, combined with the big-spending economic “stimulus” a compliant Congress is sure to give incoming President Barack Obama, may spark enough economic activity to reverse economic decline — for a while.

The economic forecast Chapman’s Anderson Center just released projects that housing prices are close to their bottom, and the country should start to come out of recession toward the end of next year.

However, since they are paying interest to the Treasury on all that capital Treasury Secretary Hank Paulson has pumped into them, banks will eventually have to start lending. When they do, unless the Fed is especially wise in the way it times its countermoves, the market will be overrun with dubious dollars, and we will face the risk of serious inflation in 2010-11.

That will mean higher interest rates and a weaker dollar, which will make imports (as well as credit and almost everything else) more expensive.

Many commentators see the current recession as a market failure. But the boom-bust cycle was clearly precipitated not by the private market but by government policies. The danger, highlighted by the Fed’s acknowledgment that it can do no more with interest rates, is the cycles will become shorter and the government will have less capacity to create artificial prosperity by printing and borrowing money.

Eventually we may decide the Federal Reserve — whose purpose never was to stabilize prices, regardless of what conventional textbooks say, but to facilitate government expansion through “managed” inflation — was a bad idea whose time has passed.

It is impossible to predict, however, how many more boom-bust cycles it will take before this becomes conventional wisdom.